I engage in seller financing and private money often both as lender and borrower. I often encourage older retired folks to consider seller financing as it can provide stable income and delay some capital gains tax. I feel I can address some of your questions, but I've never worked with a municipality so my experience is limited to private individuals.
Question 1:
Often with seller financing, as well as hard money loans, it's all about the property and less about the buyer. Get a sizable down payment (20-30% preferably, which will be taxed), and if the city defaults you get the property back with any improvements they made. I would even consider a lower down payment if the city is going to invest significant improvements to the property right away (assuming this is an undeveloped plot of land).
Question 2:
The note is an asset so the note itself will be passed on by trust or will or whatever. I believe the income while the estate is being figured out is also part of the estate so will continue to be deposited into the late family members account until the account and the note is dispersed. Double-check with an accountant, but I would assume the note's "basis" would be stepped up to current value and the capital gains tax would be avoided and only estate taxes would be considered (which if the estate is valued less than about $11 million the estate pays nothing, whereby avoiding those capital gains taxes entirely)
Question 3:
Say the city builds a school and then stops paying, you foreclose, get the land back and the school comes along wit it. Now you can sell it again, this time with a school on it, earning potentially much more.
Question 4:
Assuming they don't want to pay the taxes, and assuming they will continue to want to have the money invested, I would say the loan term would be more like amortized for 30 years, but due in 5. That way, in 5 years, you can update the interest rate or request the entire balance. Hopefully the city wants to continue with the note and hopefully interest rates are favorable in 5 years. I once bought a multifamily property from a retired person with this method almost 20 years ago, we update the interest rate every 5 years, he has spread his capital gains taxes out over at least 20 years and has had a steady monthly interest payment, I own the property and make money by running it and have never had to pay (or qualify for) a loan, which on large multifamily property can easily run $20k and is done every 5 or so years.
I don't know if a city would want to get involved with this stuff, but as long as the sellers don't need the entire balance then seller financing should definitely be considered.